The following is a summary of our recent weekly investment webinar (see The Investment Case for Emerging and Foreign Markets) where Financial Sense® Wealth Management CIO Chris Puplava outlined his thoughts on the most recent Covid data, foreign and emerging markets, bonds, and commodities for 2021.
Foreign Economies Showing Strength
Relative to the United States, foreign and emerging markets are likely to see substantial outperformance, Puplava noted, both overall economically and in terms of future returns.
The world’s second largest economy, China, is doing very well in this recovery. “China's manufacturing base is on fire,” Puplava said. “They've really ramped up production, which is obviously translating into exports. China's really weathered this whole global crisis very well.”
China has also faired relatively better than the U.S. in terms of concentration of Covid-19 cases, which will make implementation of Covid vaccines more manageable.
Meanwhile, Latin America is not even close to the same kind of concentration of cases as Europe and the U.S. have seen. Similarly, most parts of Asia are doing very well relative to other countries.
A similar trend bears out in terms of numbers of fatalities. Foreign and emerging markets are doing relatively well and operating closer to full capacity than those of Europe and the United States.
Mobility in emerging market countries has also held up, relative to pre-Covid levels. While Europe is doing poorly, and the U.S. is fairing better but not exceptionally well, emerging markets are holding up much better overall.
We have seen some turndowns in South Africa and Brazil, but other countries, such as Russia, Taiwan and South Korea, are doing relatively well on holding in there in terms of mobility. Their economies are more online than in U.S. and Europe.
Foreign Equities Likely to Outperform
Similarly, foreign and emerging market equities are likely to fare better than U.S. equities. The Chinese stock market experienced a bubble in 2014 and 2015, and has been trending sideways ever since, Puplava noted.
However, we’ve recently seen a major breakout above the 3,500 level, indicating that we might see strong gains in the Chinese stock market in the year ahead.
Japan is also breaking out. Looking at the annual rate of change in Japan's balance sheet, from 2015 until 2020, Japan really was growing its balance sheet, but at a slower rate. Now, however, because of Covid, we have seen a huge surge in the Japanese expansion of its balance sheet, which is now growing at 25 percent year-over-year.
“If you think of a market that hasn't gone anywhere, there really is no market other than Japan,” Puplava said. “It takes the cake. We're talking almost three decades where Japan hasn't gone anywhere since its bubble in 1989. This is a major breakout.”
Japanese equities may now play catch-up relative to U.S. equities in terms of performance, as they have severely lagged over the last decade.
It is important to remember that valuation is never a timing tool, Puplava noted. However, beyond one-year forward returns, the further out we look, the correlation between valuations and returns starts to strengthen.
If we just look at valuations of emerging markets priced to book relative to the S&P 500, we are currently at levels that we haven't seen in almost two decades, Puplava noted.
“The fact that these markets are just now starting to show some good performance and major breakouts, coupled with really low valuations, are two of the reasons we are very attracted to foreign and emerging markets at this time.”
There are a few factors that may lead foreign and emerging markets to outperform the U.S., Puplava stated. Weighting is a significant factor. Returns in equity markets in 2019 and 2020—as well as 15-year returns—show that the U.S. has annualized almost a 10 percent return over the last 15 years.
If we look at developed countries such as the United Kingdom, Europe and Asia, they're almost half of what U.S. returns have been.
Other emerging market equities have shown even worse performance, indicating they have a lot of potential to play catch up. In terms of market cap, if we look at the cyclical versus technology weightings in these various areas relative to the U.S., cyclical sectors make up 56 percent of the All World Index excluding the U.S. For contrast, the U.S. tech weighing is roughly 28 percent and cyclicals are around 37 percent.
The North Asia emerging markets and Japan all have higher cyclical exposure than the S&P 500, with lower technology weightings.
“If we do see a shift towards value and cyclical sectors, one of the reasons why foreign markets may outperform is simply just based on their weightings in terms of sectors relative to the U.S.” Puplava said.
Puplava expects the U.S. dollar to continue to weaken probably into 2022, he noted, and this is likely to benefit value sector cyclicals.
Two factors that lead trends in the dollar are the twin factors of the budget deficit and the trade deficit.
The twin deficits haven’t been this deeply negative in more than three decades, and really since World War II. This setup will put considerable strain on the dollar, he added, and a weaker dollar tends to coincide with cyclical out-performance.
Also, as the U.S. is set to perform relatively less well compared to emerging markets, this is likely to put further strain on the dollar. The forecast for 2020 to 2025 anticipates that the U.S. will grow at around 1.3 percent on an annual basis, while the world excluding the U.S. is expected to almost double that rate at 2.5 percent.
As that differential between foreign markets relative to the U.S. market economic growth expands, it suggests less favorable trends in the U.S. dollar, with foreign currencies gaining share as their underlying economies show stronger economic growth.
So this could be another reason why we see foreign markets outperform due to a weak dollar, not just based on our budget and trade deficits, but looking at relative growth differentials.
“You could achieve greater returns being a U.S. investor investing in these markets in their currencies,” Puplava said. “Not only could those (emerging) markets do relatively well, but by diversifying out of the U.S. dollar, you may even be able to amplify your return.”
Fixed Income Set for Troubles
It is essential to consider trends and inflation and what this does to asset returns. Currently, we are below the median inflation level, but we are very likely to see rising inflation in the next 2 years, Puplava said. This is probably going to lead to several things.
In an environment with low and rising inflation, which has occurred four times since 1988, one of the worst returns is in cash, Puplava stated.
Alternatively, commodities, emerging market equities, small caps and value sectors tend to do relatively well compared to bonds and cash.
“This is why we are moving to underweight fixed income and overweight equities,” Puplava said. “Within equities, we are moving towards real assets such as commodities and emerging market equities that all tend to do well with a weak dollar.”
Returns in fixed income have been very strong up to this point, with interest rates falling over the last several years.
However, it is important to consider the impact that just a 1 percent rise in interest rates has on returns. For a 30-year treasury, a 1 percent rise in interest rates could lead to a 21 percent price decline, and almost a 10 percent decline in 10-year treasuries.
We recently saw the 10-year move above 1 percent, Puplava noted, highlighting the importance of watching fixed income in a rising interest rate environment.
“There's a lot of sensitivity to interest rate movement,” he said. “So far, (fixed income) has been benefiting from falling rates. But bond investors need to be worried about the other side when interest rates start to rise.”
Corporate and Household Debt Outlook
We are seeing a huge surge in debt-to-GDP, Puplava stated. However, this requires some nuance. Since the housing crisis, households have repaired their balance sheets by reducing the amount of debt they have relative to income. The household debt service ratio, which looks at how much we're spending on debt payments relative to our disposable personal income, is at the lowest level in four decades.
A lot of that has to do with the level of interest rates, Puplava stated, but it does show that consumers have a tremendous amount of buying power as they're spending less on debt.
Household net worth reached a record $128 trillion and a lot of that has to do with a bull market in everything. Bonds are up. Commodities have done OK. But equity markets have done very well. This surge in consumer balance sheet assets relative to their total liabilities has strengthened the consumer debt outlook.
Where the top 10 percent of income earners tend to spend less and save more, those in the bottom 90 percent of income earners spend roughly 99 percent of their income. With a strong relative debt outlook and stimulus payments slated to go out this year, that could create a significant boost to the U.S. economy.
In contrast, corporations have levered up, and now have the highest leverage they've ever had relative to the size of the economy. The percentage of outstanding corporate BBB-rated debt, the lowest rating above junk, has trended higher over the last decade.
This is a reason why the Federal Reserve stepped in in March to bail out the bond market, Puplava stated.
The concern here is that average duration in the corporate bond market is around 9 years. That's the highest duration in three decades.
This creates a problem similar to the one we see in the Treasury bond market. The higher the duration, the more sensitive bonds are to interest rate movements. For example, a 30-year Treasury is going to move significantly more than a 10-year Treasury with a hundred basis point change in interest rates.
“We need to be really cognizant of instability in the fixed income market if we do start to see interest rates move up, both in the Treasury market as well as the corporate bond market,” Puplava said. “We're going to see some significant outperformance in foreign markets, partly due to a weak dollar, as well as their sector composition. I think we're going to see value begin to outperform growth, and I think investors really need to keep an eye on the fixed income markets, not only from an investment perspective—that there really isn't an attractive return in fixed income—but also looking at the instability that may occur if we see a rise in interest rates. We don't want to see a dramatic rise in interest rates, which tends to destabilize the market, just like a spike in oil prices. If we see a gradual rise, I think the market can absorb that. That to me will be one of the big watch points this year and into next—the level of interest rates and the market sensitivity to them.”
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Written by Ethan D. Mizer